Front Matter
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund
  • | 2 https://isni.org/isni/0000000404811396, International Monetary Fund
  • | 3 https://isni.org/isni/0000000404811396, International Monetary Fund

Abstract

This paper explores the role of exchange rates in emerging economies with inflation-targeting regimes, an issue that has become especially germane during the current episode of financial turmoil and volatile capital flows. Under inflation targeting, the interest rate is the main monetary policy tool for influencing activity and inflation, and there is little agreement about the appropriate role of the exchange rate.The exchange rate is a more important monetary policy tool for emerging economies that have adopted inflation targeting than it is for inflation-targeting advanced economies. Inflation-targeting emerging economies generally have less flexible exchange rate arrangements and intervene more frequently in the foreign exchange market than their advanced economy counterparts. The enhanced role of the exchange rate reflects these economies' greater vulnerability to exchange rate shocks and their less developed financial markets. However, their sharper focus on the exchange rate may cause some confusion about the commitment of their central banks to achieve the inflation target and may also complicate policy implementation. Global inflation pressures, greater exchange rate volatility, and the financial stresses from the global financial turmoil that began in mid-2007 are heightening these tensions.

© 2009 International Monetary Fund

Production: IMF Multimedia Services Division

Typesetting: Alicia Etchebarne-Bourdin

Figures: Thomas Wood

Cataloging-in-Publication Data

The role of the exchange rate in inflation-targeting emerging economies / Mark Stone … [et al.]. – Washington, D.C. : International Monetary Fund, 2009.

p. ; cm. – (Occasional paper, 0251-6365 ; 267)

Includes bibliographical references.

ISBN 9781589067967

1. Foreign exchange rates – Developing countries. 2. Monetary Policy — Developing countries. 3. Inflation (Finance) — Developing countries. I. Stone, M. (Mark Richard). II. International Monetary Fund. III. Occasional paper (International Monetary Fund) ; no. 267.

HG3877.R65 2009

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Contents

  • Preface

  • I Executive Summary

    • Summary of Key Findings

  • II Introduction

  • III Why the Exchange Rate Plays a Large Role in Emerging Economies

    • Pass-Through from the Exchange Rate to Inflation

    • Output Stability

    • Financial and External Stability

    • Underdeveloped Financial Markets

    • Credibility

    • Other Exchange Rate Policy Channels

  • IV Different Roles for the Exchange Rate and the Policy Trade-Offs

    • A Taxonomy of Inflation-Targeting Approaches

    • Evaluation of Alternative Inflation-Targeting Approaches

  • V Foreign Exchange Market Intervention in Inflation-Targeting Policy Implementation

    • Plain Vanilla Inflation Targeting

    • Open-Economy Inflation Targeting

    • Inflation Targeting with Exchange Rate Bands

    • Exchange-Rate-Based Inflation Targeting

  • VI Transitioning to Full-Fledged Inflation Targeting

    • The Policy Role of the Exchange Rate

    • Central Bank Policymaking

    • Transparency

    • Financial Market Development

    • Financial and External Stability Policies

  • VII Implications of Recent Global Shocks

    • Inflation Pressure and Capital Inflows

    • The Global Financial and Economic Crisis

    • Implications

  • VIII Conclusions

    • Why Are Emerging Economies Particularly Concerned about the Exchange Rate?

    • How Should the Exchange Rate Be Taken into Account in an Inflation- Targeting Framework?

    • What Is the Appropriate Role of Foreign Exchange Market Intervention in Inflation-Targeting Policy Implementation?

    • What Key Issues Warrant Further Work?

  • IX Case Studies in the Role of the Exchange Rate in Inflation-Targeting Emerging Economies

    • Guatemala

    • Hungary

    • Iceland

    • Kazakhstan

    • Peru

    • Philippines

    • Singapore

    • South Africa

  • X Foreign Exchange Intervention Practices: Selected Cases

    • Azerbaijan

    • Brazil

    • Chile

    • Colombia

    • New Zealand

    • Romania

    • Serbia

    • Sweden

    • Turkey

  • Appendix I

  • Appendix II. The Small Open-Economy Model

  • References

  • Boxes

    • 2.1. Country Groups Used in the Analysis

    • 5.1. Foreign Exchange Intervention: Matching Objectives and Practices

    • 5.2. Foreign Exchange Intervention in Emerging Economies

    • 5.3. Transparency of Foreign Exchange Intervention

    • 9.1. The National Fund of the Republic of Kazakhstan

  • Figures

    • 4.1. Plain Vanilla Inflation Targeting in a Robust Advanced Economy and a Vulnerable Emerging Economy

    • 4.2. Alternative Policy Rules and the Variability of Inflation and Output in Advanced and Emerging Economies

    • 4.3. The Impact of an Exchange Rate Objective on the Variability of Inflation and Output in Robust Advanced and Vulnerable Emerging Economies

    • 4.4. Performance of Alternative Policy Rules on Macroeconomic and Financial Volatility in Advanced and Emerging Economies

    • 7.1. Emerging Market Inflation-Targeting Economies, External Vulnerability and Foreign Exchange Intervention

  • Tables

    • 2.1. Exchange Rate Arrangements and Foreign Exchange Intervention Practices (Selected Countries)

    • 2.2. Exchange Rate and Reserve Volatility, 1996–2007 (Selected Countries)

    • 3.1. Dollar Deposits, Share of Total (Selected Countries)

    • 3.2. Market Development Indicators (Selected Countries)

    • 3.3. Indicators of Credibility (Selected Countries)

    • 7.1. Inflation-Targeting Economies, Macroeconomic and Policy Developments, December 2006–August 2008

    • 7.2. Inflation-Targeting Economies, Macroeconomic and Policy Developments, August 2008–March 2009

    • 9.1. CBI: Exchange Rate Considerations in Monetary Policy during 2006

    • 9.2. Monetary Authority of Singapore: Policy Developments since 1981

    • A1.1. Intervention Practices of Inflation-Targeting Economies, Late 2007

    • A1.2. Intervention Practices of Emerging Economies with Other Anchors, Late 2007

    • A2.1. Parameter Calibration of the Advanced and Emerging Economy Models

    • A2.2. Reaction Function Coefficients

The following conventions are used in this publication:

  • In tables, a blank cell indicates “not applicable,” ellipsis points (…) indicate “not available,” and 0 or 0.0 indicates “zero” or “negligible.” Minor discrepancies between sums of constituent figures and totals are due to rounding.

  • An en dash (–) between years or months (for example, 2007-08 or January-June) indicates the years or months covered, including the beginning and ending years or months; a slash or virgule (/) between years or months (for example, 2007/08) indicates a fiscal or financial year, as does the abbreviation FY (for example, FY2008).

  • “Billion” means a thousand million; “trillion” means a thousand billion.

  • “Basis points” refer to hundredths of 1 percentage point (for example, 25 basis points are equivalent to ¼ of 1 percentage point).

As used in this publication, the term “country” does not in all cases refer to a territorial entity that is a state as understood by international law and practice. As used here, the term also covers some territorial entities that are not states but for which statistical data are maintained on a separate and independent basis.

Preface

This Occasional Paper explores the role of exchange rates in emerging economies with inflation-targeting regimes, an issue that has become especially germane during the current episode of financial turmoil and volatile capital flows. Under inflation targeting, the interest rate is the main monetary policy tool for influencing activity and inflation. However, there is little agreement about the appropriate role of the exchange rate. The need for further understanding of this issue is manifest in the wide array of exchange rate practices undertaken by emerging market economies, the dearth of academic analysis of this issue, and the high demand for IMF technical assistance on exchange rate issues among emerging economies that currently have inflation-targeting regimes or intend to adopt inflation targeting. This paper benefits from the unique perspective available to the IMF as a result of its near-universal membership and its cross-country analytical and operational work on the role of the exchange rate, which is at the core of the IMF’s work on surveillance. This paper benefited from discussions with Karl Habermeier, the contribution of Carlos José Garcia Toledo to the modeling, and the research assistance of Harald Anderson and Claudia Jadrijevic.

The opinions expressed in this paper are solely those of the authors and do not necessarily reflect the views of the International Monetary Fund or its Executive Directors.

Hervé Ferhani

Deputy Director

Monetary and Capital Markets Department

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